Variable universal life insurance might be the most misunderstood type of permanent life insurance available. This may be because it has the same significant benefit of whole life insurance (the death benefit) and the same premium flexibility of universal life.
In this article, we’ll look at what makes variable universal life (VUL) a unique form of permanent life insurance, the pros and cons of VUL, and more.
What is variable universal life insurance?
Like whole life and universal life, variable universal life is a type of permanent life insurance, meaning that as long as you continue to pay your premiums, your beneficiaries will receive a death benefit when you pass away. Similar to whole life and universal life, VUL also has a cash value component that grows with each premium payment you make.
The cash value of VUL is invested in mutual funds containing stocks or bonds. If the mutual funds perform well and the cash value continues to grow, some of the cash value can defray a portion or all of the premium.
For someone who has exhausted all of their other investment options, VUL can be an effective way of expanding an investment portfolio, have tax-deferred growth, and secure financial protection for loved ones.
VUL offers a higher potential for cash value growth than whole life insurance, though it is significantly more expensive than term life insurance. In contrast, owners of term life insurance can experience investment gains equal to or greater than that of variable universal life.
A brief history of variable universal life insurance
Variable life insurance has been available since the early 1980s. When interest rates started to rise in the 80s, policyowners of dividend-paying life insurance policies saw these increasing interest rates and noticed that their dividend paying whole life policies weren’t keeping up.
This was the beginning of the movement, made famous by A.L. Williams, advocating that people buy term life insurance and invest the difference in the premium between whole life insurance and term insurance. They asked, “Why not invest the difference in a money market account that is paying double the dividend rate of my whole life policy?”
This ultimately led to a rush of people who wanted to cash in their whole life policies. As a result, the life insurance companies developed a solution to this quandary: universal life insurance.
While not offering the guarantees of whole life, universal life did offer flexibility and greater potential for cash value growth, comparable to the money market accounts that were so enticing to whole life policyholders.
Another event in the 1980s that would affect the life insurance industry was the stock market. With it averaging close to a growth rate of 15% per year, people concluded that they wanted a life insurance policy with mutual funds as the vehicle to build their cash values. Thus, enter variable universal life insurance.
Nearly 40 years later, VUL is still a viable option today. It has remained essentially the same, except the selection of mutual funds available to the policyholder has dramatically increased. People have clamored for more choices of funds to grab the healthy gains of the stock market.
Pros and cons of variable universal life insurance
Life insurance agents that still recite the mantra of “Buy term and invest the difference” speak very unfavorably about VUL. While there are some negatives with it, there are also some positive aspects of the product. Let’s look at both.
Pros of VUL
Life insurance agents that sell it and the people that buy it believe that VUL is the perfect life insurance policy
Variable universal life insurance provides a death benefit that will be paid to a beneficiary that the insured names when they apply for the policy. This death benefit is provided income tax-free to the beneficiary when the insured dies, helping them avoid massive financial hardship from the loss of income that was provided by the insured.
While it may seem unnecessary to say that this life insurance policy has a death benefit, it deserves to be mentioned because it is permanent life insurance, and the life insurance won’t expire as long as you keep paying the premium. This differs from term life insurance, where the insurance protection expires, typically after 10, 20, or 30 years.
It should also be noted that with VUL, there is no endowment age (the age at which the cash value is the same as the death benefit amount) as there is with whole life insurance.
Any time you see the word “universal” in the name of a life insurance policy, you can assume that the premiums are flexible. With VUL, that is the case. The premiums can increase or decrease for several reasons:
- You can choose to raise or lower the policy’s death benefit, which affects the premium. Bear in mind that increasing the death benefit will require evidence of insurability.
- Your cash value’s performance may allow you to lower your premium. For example, if your monthly premium is $400, you can choose to pay $200 out-of-pocket and use your cash value to pay the rest of the premium.
- You can skip premium payments entirely if your cash value is large enough.
- You can also overfund your policy’s cash value in the early years, so the investment gains grow more quickly. This is a good option for high-earners that want to have the option of not paying premiums later on, such as when they retire.
No rate cap
VUL carries no rate cap, unlike indexed universal life that has both a cap and a floor. For example, with VUL, if a mutual fund in the account returns a rate of 20%, the policyholder’s cash value receives the full 20%, unlike indexed universal life that may cap the return to the policyholder at 12%.
Like all types of life insurance with a cash value component, all the gains in the cash value are tax-deferred, and the death benefit is paid out to the beneficiary tax-free.
Money can be withdrawn from the cash value of a VUL policy. Taxes are typically charged only on withdrawals from the policy, not loans. The withdrawals are taxed on a FIFO (First In – First Out) basis. This means that the premiums you paid that went into the cash value, not the life insurance portion of the policy, would need to be completely depleted before your withdrawals would be taxed.
Because of the taxation of withdrawals, many people choose policy loans instead. Loans benefit the policyholder by being withdrawn tax-free while not depleting the cash value because the cash value receives dividends. There is interest charged on the loan, which can be considered a wash because of the dividends.
Many people take out loans at a very low interest rate, at or near 0%, and use the money as supplemental income well into their retirement years. When the insured dies, any outstanding loan amount is deducted from the death benefit of the policy.
With VUL, the policyholder decides how their cash value will be invested, unlike other permanent policies where the insurance company determines the rate of return. VUL offers a wide range of options, including equities, bonds, and money market instruments.
Cons of VUL
This is a big negative for many people. When the premium payment is made, a portion goes to pay for the policy's death benefit, and a portion goes into the policy’s cash value, where the risk is transferred to the policyowner.
While VUL’s offer the attractive feature of potentially large gains, the cash value of a VUL policy can drop quickly in a very short period of time, which is determined by the performance of the stock and bond markets. In 2008 and 2020, there were mutual funds that lost more than 50% of their value in just a month or two. This means that there is substantial risk when you enter the market.
Because of VUL being invested in the financial markets, additional fees for oversight, policy charges, and mutual fund management fees make it more costly per year than a comparable universal life policy.
With VUL, the policyholder has the responsibility of managing multiple investment accounts. Many policies offer 50 or more funds, also called separate accounts, which the policyholder must evaluate before deciding how to invest. Investing requires oversight on the part of the policyholder, and they must continue to monitor the performance of their funds to ensure positive growth of the cash value.
Whole life has a guarantee, universal life has a guarantee, but not VUL. VUL can provide a death benefit guarantee up through a certain age, but it’s just the bare minimum and is no better than term life insurance.
Investment performance is not guaranteed, and the cash value could conceivably drop to near zero under catastrophic financial conditions.
Is “buy term and invest the difference” a better philosophy?
Many people believe it is. Most people only need to have life insurance protection for a set period of time, such as when they have a 30-year mortgage or the kids will be going to college after graduating high school. They also don’t want to pay the high fees of the mutual funds offered with VUL when they can invest in mutual funds with little or no fees themselves or with the help of a financial advisor.
In conclusion, VUL can be advantageous to high-income earners that have exhausted their tax-advantaged investment opportunities, like their retirement plan at work or a Roth IRA. For others, buying term life insurance and investing the difference themselves makes more sense. With life insurance, one size doesn’t fit all.
Having grown up in upstate New York, Bob Phillips spent over 15 years in the financial services world and has been making freelance writing contributions to blogs and websites since 2007. He resides in North Texas with his wife and Doberman puppy.
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